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Capital formation or (capital accumulation), is very important for economic development.

Definition and Explanation:

Capital formation or accumulation is the process of building up the capital stock of a country through investing in productive plants and equipments. Capital formation, in other words, involves the increasing of capital assets by efficient utilization of the all available resources of the country.

Resources for Capital Formation and its Importance:

The stock of capital goods can be built up and increased through two main sources:

(1) Domestic Resources and (2) External Resources.

(1) Domestic Resources for Capital Formation with Examples:

Domestic resources for capital formation play an important part in promoting development activities in the country. These sources are in brief:

(i) Voluntary Savings: There are two main sources of voluntary savings (a) households (b) business sector. As regards the volume of personal savings of the households. It depends upon various factors such as the income per capita, distribution of wealth, availability of banking facilities, value system of the society, etc.

In the under-developed countries, the saving potential of the people is low as a greater number of them suffer from absolute poverty. So far as the rich section of the society is concerned, they mostly spend their wealth on the purchase of real estates, luxury goods, or take it abroad to safe keeping. There is, therefore very little savings forthcoming from the high income group.

The business sector is an important source of voluntary savings in the less developed countries. They usually hesitate in assuming the risks associated with investment. The fear of nationalization and political instability further demands their incentive to save and invest in the country. The statistics of many underdeveloped countries indicate that both these sources hardly manage to save 15% of their GDP. This is not even sufficient to maintain the present standard of living of the masses.

(ii) Involuntary Savings: In the developing countries, the income per capita of the people is low. Their propensity to consume mainly due to demonstration effect is very high. As the flow of savings is inadequate to meet the capital needs of the country, the government, therefore adopts measures which restrict consumption and increase the volume of savings.

The traditional methods used for increasing the volumes of savings are (a) taxation (b) compulsory schemes for lending to the government. The two fiscal measures stated above are very sensitive and delicate. They should be devised and handled very carefully.

For example, if the people of low and middle income groups are heavily taxed through various forms of taxation, their power, (whatever little) to save will be burdened with taxes. The tax structure is to be devised in such a manner that it should provide incentive to work, save and invest for various levels of income groups.

(iii) Government Borrowing: The volume of domestic savings can also be increased through government borrowing. The government issues long and short term bonds of various denominations and mobilizes saving from the general public as well as from the financial institutions.

In the developing countries, there are many obstacles which stand in the way of government’s borrowing. For instance, the money and capital market is unorganized. The rural sector is not provided with adequate financial institution. People being illiterate prefer to invest their savings in gold, jewellery, etc. The government of developing countries should, therefore, evolve a workable programme of mobilizing the savings of the people both in the urban and rural sectors.

(iv) Use of Idle Resources: In the developing countries of the world there are many resources which remain unutilized and underutilized. If they are properly tapped and diverted to productive purposes, the rate of capital formation can increase rapidly.

For example, in most of the low income countries, there is a disguised unemployment in the rural sector. If the surplus farmers are employed at nominal wages in or near their villages for the construction of roads, tube-wells, canals, school buildings, etc., or their services are acquired on self-help basis for capital creating projects, they can be a valuable source of capital formation in the country.

(v) Deficit Financing: Deficit financing is regarded an important source of capital formation. In the developed countries this method is used for increasing effective demand and ensuring continued high levels of economic activity. In the less developed countries, it is used to meet the development and non development expenditure of the government.

(2) External Resources for Capital Formation with Examples:

External resources for capital formation (accumulation) has following types:

(i) Foreign Economic Assistance: There is a controversy over the impact of inflow of capital for the development of a country. It is argued that capital is one of the variable in the growth process. If the government of a country is ineffective and people are not receptive to social changes, the inflow of capital resources and technical assistance would go waste.

In case, the developing nations needing foreign capital and technical assistance have the will to absorb capital and technical knowledge and the social and political barriers are overcome, capital then becomes the touchstone of economic development. The main benefits of the foreign economic assistance, however, in brief are as under:

(a) Foreign loans bridge saving gap. In Pakistan, like most of the developing countries, the domestic saving average 14% of GDP. The low rate of saving is not sufficient to achieve the desired rate of growth in the country. Foreign loans supplement domestic savings and help in bridging the resource gap between the desired investment and the domestic savings.

(b) Close the trade gap. In Pakistan, the export earnings are persistently falling short of import requirements. The foreign, exchange gap caused by excess of import/export is being filled up with inflow of capital.

(c) Provides greater employment opportunities. The financing of various projects with the help of foreign assistance provides greater employment opportunities in a country.

(d) Increase in productivity of various economic sectors. The inflow of capital and technical know-how increases the productive capital of various sectors of the economy.

(e) Increase in real wages. The foreign resources help in increasing marginal productivity of labor in the recipient country. The real wages of the workers are thus increased with the help of foreign assistance.

(f) Provision of higher products. The foreign capital helps in the establishment of industries in the country. The inflow of technical knowledge improves the quantity and quality of manufactured goods and makes them available at lower prices to the domestic consumers.

(g) Increase in tax revenue. The profits earned on foreign investment are taxes by the government, The revenue of the state is thus increased.

(h) External economies. The inflow of foreign capital and advanced technology stimulates domestic enterprises. The firm avails of the benefits of external economies like that of training of labor, introduction of new technology, new machinery, etc., etc.

(ii) Donor Countries and the Economic Assistance: Here a question can be asked as to why the developed nations are kind in giving aid to the developing countries? According to the rich nations, the foreign aid is given for a combination of humanitarian and self-interest reasons:

(a) Humanitarian ground. If a country is faced with famine, drought, epidemic, diseases, earthquake etc., it is obligatory for the developed nations to help that country financially purely on humanitarian grounds. The rich countries are extending economic assistance in the form of grants to the poor nations of the world.

(b) Self-interest reasons. Foreign economic assistance is also provided on the following self interest reasons by the donor countries.

(a) The foreign aid may be given to protect the developing country from the influence of-other camp countries.

(b) The donor countries may have surplus products. In order to check the fall in the prices of products in the domestic market and to maintain level of production, the surplus goods are exported to the needy countries on loan.

(c) Economic assistance is also provided by the donor countries to remove the economic disparities among the nations of the world.

(d) Some advanced nations particularly the socialist countries provide financial and technical help for the propagation of political ideology in the capitalist developing countries.

(e) Foreign aid is also given for increasing the camp followers of the donor countries.

Relation between Capital Formation and Economic Development:

Capital is one of the important factors which governs the quantity and the composition of output in a country.

If there are increasing resources of capital in a country, it results in technological discoveries, raises productivity of labor, increases the rate of economic development and provides higher standard of living for the masses.

In case, there is deficiency of capital assets such as machinery, equipment tools, dams, roads, railways, bridges, etc., the country then remains trapped in the vicious circle of poverty.

It may here be remembered that though capital occupies a central position, to the process of economic development yet, we cannot ignore the other factors like education, effective government, social justice, attitude of the people to work, etc. These factors also play significant role in the economic development of a country.

Economic development is thus a multidimensional phenomenon which is the result of combination of social, cultural, political, and economic factors.

To quote Ranger Nurkse:

Economic development has much to do with human endowments, social attitudes, political conditions, and historical accidents. Capital is necessary but not a sufficient condition of economic progress”.